The Keynesian Consumption Function (Part - 2) - Macroeconomics | Macro Economics - B Com PDF Download

Keynes’s Theory of Consumption:

Keynes in his “General theory”, published in 1936, laid the foundations of modern macroeconomics. The concept of consumption function plays an important role in Keynes’ theory of income and employment. Keynes mentioned several subjective and objective factors which determine consumption of a society. However, according to Keynes, of all the factors it is the current level of income that determines the consumption of an individual and also of society.

Since Keynes laid stress on the absolute size of current income as a determinant of consumption, his theory of consumption is also known as absolute income theory of consumption. Further, Keynes put forward a psychological law of consumption, according to which, as income increases consumption increases but not by as much as the increase in income. In other words, marginal propensity to consume is less than one.

1> ΔC/ΔY>0

While Keynes recognized that many subjective and objective factors including interest rate and wealth influenced the level consumption expenditure, he emphasised that it is the current level of income on which the consumption spending of an individual and the society depends.

To quote him:

“The amount of aggregate consumption depends mainly on the amount of aggregate income. The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from (the detailed facts of experience is that men (and women, too) are disposed, as a rule and on an average to increase their consumption as their income increases, but not by as much as the increase in their income.”

In the above statement about consumption behaviour, Keynes makes three points. First, he suggests that consumption expenditure depends mainly on absolute income of the current period, that is, consumption is a positive function of the absolute level of current income. The more income in a period one has, the more is likely to be his consumption expenditure in that period. In other words, in any period the rich people tend to consume more than the poor people do. Secondly, Keynes points out that consumption expenditure does not have a proportional relationship with income.

According to him, as the income increases, a smaller proportion of income is consumed. The proportion of consumption to income is called average propensity to consume (APC). Thus, Keynes argues that average propensity to consume (APC) falls as income increases.

The Keynes’ consumption function can be expressed in the following form

C = a + bY_d

where C is consumption expenditure and Y_d is the real disposable income which equals gross national income minus taxes, a and b are constants, where a is the intercept term, that is, the amount of consumption expenditure at zero level of income. Thus, a is autonomous consumption. The parameter b is the marginal propensity to consume (MPC) which measures the increase in consumption spending in response to per unit increase in disposable income. Thus

MPC = ΔC/ΔY

Since the average propensity to consume falls as income increases, the marginal propensity to consume (MPC) is less than the average propensity to consume (APC). The Keynesian con­sumption function is depicted in Figs. 6.3.

In Fig. 6.3 we have shown a linear consumption function with an intercept term. In this form of linear consumption function, though marginal propensity to consume (ΔC/ΔY) is constant, average propensity to consume is declining with the increase in income as indicated by the slopes of the lines OA and OB at levels of income Y₁ and Y₂ respectively. The straight line OB drawn from the origin indicating average propensity to consume at higher income level Y₂ has a relatively less slope than the straight line OA drawn from the origin to point A at lower income level Y₁.

The decline in average propensity to consume as the income increases implies that the proportion of income that is saved increases with the increase in national income of the country. This result also follows from the studies of family budgets of various families at different income levels. The fraction of income spent on consumption by the rich families is lower than that of the poor families. In other words, the rich families save a higher proportion of their income as compared to the poor families.

The assumption of diminishing average propensity to consume is a significant part of Keynesian theory of income and employment. This implies that as income increases, a progres­sively larger proportion of national income would be saved. Therefore, to achieve and maintain equilibrium at full-employment level of income, increasing proportion of national income is needed to be invested.

If sufficient investment opportunities are not available, the economy would then run into trouble and in that case it would not be possible to maintain full-employment because aggregate demand will fall short of full-employment output. On the basis of this in­creasing proportion of saving with the increase in income and consequently, the emergence of the problem of demand deficiency, some Keynesian economists based the theory of secular stagnation on the declining propensity to consume.

Determinants of Propensity to Consume:

The important question is on what factors the propensity to consume of a community depends. In other words, what are the factors that determine the level and position of the pro­pensity to consume or the consumption function? Keynes divided the factors determining the propensity to consume into two groups: the first group of factors was called by him as subjective factors and the second group was named by him as objective factors. We shall explain below in detail these subjective and objective factors which affect the consumption function of a com­munity.

Subjective Factors:

Among the subjective factors are included those factors which induce and prompt people to save some part of their income. First, people save because they want to provide for unforeseen contingencies, such as illness, unemployment, accidents, etc. Secondly, people are induced to save because they want to provide for the expected future needs such as education of the children, marriages of their children, etc.

Thirdly, several people wish to save from their current incomes so that they may be able to use accumulated savings for investment which will increase their future income. Investments will bring them more income in the form of more profits and interest. Fourthly, people are motivated to save so that they can accumulate large wealth which will increase their social status.

With increased wealth they would think themselves to be economically more independent and they could buy many things with more wealth. Further, many individuals also save so that they can use them for speculative pur­poses and other business projects.

Besides, several people are prompted to save for the sake of leaving a good fortune for their heirs and children. Lastly, many people save because of their miserly instinct and habits. The accumulation of more wealth gives them a great psychic satisfaction.

The above subjective factors increase the propensity to save and therefore reduce the pro­pensity to consume. These subjective factors play a crucial rule in determining the level and shape of the consumption function. However, Keynes pointed out and rightly so that some subjective factors raise the propensity to consume.

The desire for ostentation generally leads to greater consumption expenditure. People have a natural in stint to imitate others’ consumption habits. As pointed out by Duesenberry, people in lower and middle income ranges imitate the consumption standards of the higher income groups and this increases their propensity to con­sume. This has been called demonstration effect which is a great subjective or psychological force that works in raising the propensity to consume.

Subjective factors also lead the business firms to save much or little from their incomes.

Many of the subjective factors which influence the savings of the firms are the following:

(1) Enterprise:

Many business industrial firms desire to save a part of their current income so that they can make investment in new enterprises and carry out expansion in the future. Busi­ness firms generally save a good part of their income for their further expansion.

(2) Liquid­ity:

Business firms also are induced to save so that they can face contingencies in the future. If they have good amount of liquid wealth in their hands, they would be able to meet the emergent situations more successfully. More cautious and farsighted firms will save more than others on this count.

(3) Successful Management:

Many managers of the business firms are motivated to save more because they want prove themselves successful managers. With the investment of the saved money, the income of a firm increases and their managers are regarded as successful.

(4) Financial Prudence:

Business firms desire to save for making up the depreciation in plant and machinery. Since after some years business firms have to replace their plant and machinery, if a good part of their current income is not saved, it would not be possible for them to replace plant and machinery.

If the firms put aside a greater part of their income for depreciation or replacement purposes, they would pay lower dividends to the shareholders and this will generally lower the propensity to consume of a community.

On the other hand, if the firms keep a relatively small amount for depreciation, they will pay larger amounts as dividends to the shareholders and this will generally increase the propensity to consume of the community. Lastly, firms also want to save because they have to repay their debts.

Objective Factors:

Keynes mentioned the following six types of objective factors which influence the con­sumption function:

(1) Changes in the General Price Level: Real Balance Effect:

The general price level is an important factor which influences the consumption of a community. When the general price level increases or, in other words, when inflation occurs, the consumption function shifts downward. This is because the rise in the general price level, real value (that is, purchasing power) of people’s money balances and financial assets with fixed monetary values declines.

This causes a downward shift in the consumption function. This is called real balance effect. Similarly, when the general price level falls, real value of money balances and financial assets increases. This will induce people to consume relatively more out of their current income. This will cause an upward shift in the consumption function.

(2) Fiscal Policy:

Fiscal policy of the Government, especially taxation policy affects the propensity to consume of the country. By levying excise duties, sales tax, the Government can cut down the consumption and thereby increase savings of the community.

Likewise, when the Government reduces taxes, consumption of the people increases and this raises the propensity to consume. Rationing and price control by the Government also affects the propensity to con­sume, as was witnessed during the Second World War.

In the modern times, pursuing of the welfare state policy by the Government under which progressive taxes have been levied on the rich people and the revenue obtained from them have been spent to provide many social security benefits and amenities to the poor people, has tended to raise the consumption function.

(3) Rate of Interest:

Rate of interest also affects the propensity to consume and save. It is generally believed that higher rate of interest induces the people to save more and this results in reducing their propensity to consume. But this is not true in the case of all the people. Some individuals are of such a type who wants a certain fixed income in the future.

And when the rate of interest rises these individuals consume more and save less because with higher rate of interest they can obtain the given fixed income with lesser savings. Therefore, when the rate of interest rises such individuals save less than before. Thus, it cannot be said with certainty whether with the changes in the rate of interest the propensity to consume of the whole com­munity will change or not.

(4) Stock of Wealth:

The stock of wealth owned by the households in the economy is also an important factor that determines propensity to consume. In wealth we include not only real assets such as land, houses, automobiles but also financial assets such as cash balances, saving and fixed deposits with banks, stocks and bonds possessed by households. The greater the amount of wealth accumulated by households in the economy, the greater is generally the propensity to consume (i.e. the greater the amount of consumption out of any level of current income).

The important motive of the people to save is to accumulate wealth. Generally speaking, the greater the wealth which people have accumulated, the weaker is the incentive to save further. In other words, the other things remaining the same the increase in wealth generally causes an upward shift in the consumption function and decrease is wealth causes a downward shift in the consumption function.

An important example which is often cited to emphasise the importance of wealth as a determinant of consumption is the stock market crash of 1929 in England (i.e. drastic fall in share prices) which substantially reduced the financial wealth of the households overnight re­sulting in shifting the consumption function downward.

(5) Credit Conditions and Consumer Indebtedness:

The availability of easy credit causes an increase in consumption and shifts the consumption function upward. It is now a common experience in India that in recent years lowering of lending interest rates by Indian banks on loans for houses, cars, computers and other durable consumer goods has greatly increased the consumption of the people and shifted consumption function upward.

On the other hand, tight­ening of credit produces an opposite effect, that is, causes a downward shift in the consumption function, Furthermore, the recent increase in facilities of Credit Cards by banks and their ac­ceptance buy sellers of consumer goods have also worked to shift the consumption function upward in India.

Similarly, the level of consumer indebtedness also greatly affects the propensity to consume of the people. If the households are heavily indebted, say 25 to 30 per cent of their current, they are committed to save (i.e. consume less) to that extent so that they are able to pay their installments of previous credit taken. Thus, the greater the degree of indebtedness of households in the economy, the higher will be the consumption function curve and vice versa.

(6) Income Distribution:

Lastly, distribution of income in a society also determines the level of consumption function. If national income is more unequally distributed, the lower will be the propensity to consume. This is because propensity to consume of the rich is relatively less as compared to that of the poor. Therefore, if inequalities in income distribution increase, this reduces the consumption out of any given level of national income and thus causes a downward shift in the consumption function.

(7) Windfall Gains and Losses:

Windfall gains and losses also affect the propensity to consume. When the prices of the shares go up, the shareholders begin to think themselves better off and this raises their consumption. On the other hand, when the prices of the shares go down, the shareholders have to suffer sudden losses and they begin to think themselves relatively poorer than before. This induces them to reduce their consumption. We thus see that the windfall gains and losses affect the propensity to consume.

(8) Change in Expectations:

Changes in the expectations of the people also influence the propensity to consume. When people expect that war will break out in the near future and they expect prices to go up, then they will try to spend more on goods so as to meet the needs of the immediate future.

This raises the consumption function in the current period. On the other hand, when people expect the prices to fall they reduce their current consumption so that they should spend more when the prices actually fall.

We have explained above various subjective and objective factors which taken together determine the consumption function of a community. It is worth noting that propensity to consume does not generally change in the short run, because it depends more on psycho­logical and institutional factors which change only in the long run.

The institutional factors which determine the distribution of income in the society are important forces determining the consumption function. And these institutional factors do not change in the short run. Therefore, Keynes was of the view that consumption function remains stable in the short run.

Important Features of Keynes’ Consumption Function:

In macroeconomics, Keynes’s consumption function plays a highly important role. There­fore, it is essential to state its important features.

The following are the important features of Keynes’s consumption function:

1. First, absolute level of current income is the important factor that determines con­sumption of the community. Increase in national income causes an increase in con­sumption. On the other hand, classical economists thought that it was rate of interest that primarily determined saving and consumption of the community. A rise in rate of interest induces the people to save more and thus to reduce their level of con­sumption.

According to Keynes, though rate of interest is one of the factors that determine consumption of the community, he did not consider it a very important determinant of it. By considering level of current income as the most important factor determining consumption and saving, Keynes made a significant contribution to the macroeconomic theory.

2. The second important feature of Keynes’ consumption function is that marginal pro­pensity to consume is less than one but greater than zero (0 < MPC < 1). As has been explained above, the feature of Keynes’s consumption function that marginal propensity to consume is less than one is known as Keynes’s psychological law of consumption. According to this law, as income increases, consumption increases but not as much as the increase in income.Keynes’s theory of multiplier is based on the marginal propensity to consume being less than one but greater than zero.

3. In Keynes consumption function, namely, C = a + by, as income increases, average propensity to consume (APC) falls. Keynes was of the view that rich people relatively save a higher proportion of their income so that at higher levels of income average propensity to consume (APC), that is, proportion of total consumption to national income falls as national income rises.

4. Another important feature of consumption function as put forward by Keynes is that it remains stable in the short run. Consumption function, according to Keynes, de­pends on various institutional factors such as distribution of income and wealth and psychological factors such as willingness to save.

Since there cannot be much changes in these institutional and psychological factors, consumption function remains stable in the short run, that is, it does not shift upward or downward. Therefore, Keynes in his theory explains the determination of income and employment in the short run by considering that the consumption function is stable.

We shall critically examine Keynes’s consumption function and compare it with other theories of consumption function.

Consumption Function Puzzle: Keynes’ Consumption Function and Kuznets Findings:

Empirical studies of long-term times series data of the US economy for the period 1869- 1938 made by the noted American economist Kuznets estimated a consumption function which contradicts Keynes’ consumption function which was found to be correct on the basis of cross- section studies of household budget data and short-term time series data.

This contradiction between Kuznets empirical findings and Keynes’ consumption function has been called con­sumption function puzzle. Efforts have been made by several economists to resolve this puzzle and new theories of consumption function have been put forward to resolve the conflict between Keynes’s consumption function and Kuznets’s findings.

To compare the Keynes’ and Kuznets’s consumption functions, it will be useful to write them in algebraic form and graphically represent them.

Keynes’s consumption function can be algebraically written as below:

C = a + bY

where a is a positive intercept term which is also called autonomous consumption as it does not vary with income. The constant a shows that even when income is zero, a certain con­sumption is present. This is possible when in any year a community can live either on its past savings or borrow from other communities. Keynes’ consumption function is shown in Fig. 6.7.

Secondly, b in the consumption function represents marginal propensity to consume (ΔC/ΔY). The above mentioned Keynes’s consumption function (C = a + bY) shows that average propensity to consume (C/Y) falls as income increases. This can be known by comparing slopes of the rays OA an OB at income levels Y₁ and Y₂ respectively in Fig. 6.7.

Kuznets’s Consumption Function:

On the other hand, Kuznets found that consumption function is of the following form:

C = bY

In Kuznets’ consumption function there is no intercept term (that is, autonomous con­sumption). This is shown in Fig. 6.8 where it will be seen that Kuznets consumption function curve starts from the origin and is very near to 45° line depicting that the propensity to consume (b) is very high. From his empirical study Kuznets estimated that average propen­sity to consume was nearly 0.9.

Besides, by dividing the entire period (1869-1933) into three over lapping 30 years sub-periods Kuznets found that the proportion of consumption to income (that is, average propensity to consume) was nearly the same and equal to about 0.87 in all the three sub-periods.

Thus Kuznets concluded that there was no tendency for the average propensity to consume to decline as disposable income rises. Thus, rounding off Kuznets estimated propensity to consume is equal to 0.9. His consumption function presented in equation (2) can be rewritten as

C = 0.9 Y

From the above discussion it follows that implication of Keynes’s consumption function (C = a + bY) and Kuznets consumption function (C = bY) are different. Whereas in Keynes’ consumption function APC falls as income rises, in Kuznets’s function it remains constant over a long period. Further, the value of marginal propensity to consume which is less than one is much higher in Kuznets’s function as compared to that of Keynes.

The reconciliation between two types of consumption functions has been made by some economists by pointing out that whereas Keynes’s function is short-run consumption function Keznets’s function is concerned with long run and is referred to as long-run consumption function. In the long run, short run consumption function curve shifts above and therefore in the long run consumption function, propensity to consume is higher as compared to that in the short run.

Further, Friedman’s permanent Income Hypothesis and Modigliani’s Life Cycle Hypothesis have also tried to reconcile the two functions by referring to the short-run and long-run consumption behaviour of the people. We will discuss these consumption hypotheses in the appendix.

Importance of Consumption Function:

The concept of consumption function is greatly important both in theory and actual practice. To remove unemployment and to control economic fluctuations in the economy, it is very es­sential to adopt a proper macroeconomic policy. In the formation of such a policy, understanding of the concept of propensity of consume is very essential. Therefore, Prof. A.H. Hansen has remarked that “consumption function is epoch-making contribution of Keynes to economic the­ory”.

We shall explain below some of the theoretical and practical importance of this consump­tion function:

(1) The concept of consumption function helps us to invalidate Say’s law of classical economics. In fact, Keynes relied on his consumption function for proving the invalidity of Say’s law. According to Say’s law, every supply creates its own demand and therefore there is no problem of deficiency of aggregate demand. Therefore, general overproduction and unem­ployment in the economy is not possible because adequate amount of aggregate demand is ever present. Now, according to the Keynesian consumption function, when income increases con­sumption increases less than the increase in income and therefore saving gap emerges between income and consumption.

This saving gap implies that all output produced may not be sold and the problem of deficiency of demand will arise unless this saving gap is matched by an equal amount of investment demand. There is no guarantee that the saving done will be automatically invested or, in other words, it is not necessary that investment demand will be equal to the saving gap. Thus, the contention of the Say’s law that every supply creates its equal demand is not valid. No doubt, every supply or production creates income equal to the output produced.

But since all income is not consumed and there is no guarantee that investment will be equal to the saving so emerged, Say’s law is proved invalid. When investment is less than the saving gap corresponding to full-employment level of income, the aggregate demand is not sufficient to provide full-employment to the people and other resources. Thus, the problem of deficiency of effective demand and hence general unem­ployment and overproduction arises in a free enterprise capitalist economy.

(2) The concept of propensity to consume is also important because it brings out crucial significance of investment demand for determination of the level of income and employment in a capitalist economy. From the concept of propensity to consume we know that consumption increases less than the increase in income and as a result gap emerges between income and consumption.

To maintain a certain given level of income and employment, gap between income and consumption at that level must be bridged by investment expenditure otherwise it will not be possible to maintain that level of income and employment because aggregate demand would not be large enough.

This indicates the crucial importance of the investment demand in the determination of income and employment. To prevent the establishment of underemployment equilibrium in the economy or, in other words, for achieving full-employment equilibrium, in­vestment demand must be equal to the saving gap at the level of full-employment. Keynes also showed that consumption function remains stable in the short run and therefore economic fluc­tuations in a capitalist economy are largely due to the fluctuations in investment demand.

Thus from the concept of propensity to consume it follows that investment demand is vitally important in determining the level of income and employment. If it were possible to raise the propensity to consume in the short run, then without raising investment, we could have raised the level of income and employment. Since propensity to consume at a given level of income generally remains stable, we have to increase investment for achieving full employment in the economy.

(3) Another crucial importance of the concept of propensity to consume is that we derive the theory of multiplier from it which has great practical importance in the formulation of macro-economic policy, especially of public works in times of depression.The magnitude of multiplier is equal to the reciprocal of one minus marginal propensity to consume (K = 1/1-MPC) where K stands for multiplier and MPC for marginal propensity to consume. According to this concept of multiplier, when investment increases, in­come, output and employment increase by a multiple amount, depending upon the size of the multiplier.

Income increases manifold than the original investment because of the nature of consumption function. When some investment in some projects is undertaken, it leads to the increase in income of those employed in the projects but the process does not stop here.

The increases in income are further spent on consumption and this leads to further increase in income and so the chain of increases in income and consumption continues and the ultimate increase in income and employment is multiple of the original increment in investment.

If the marginal propensity to consume were equal to zero, then all increments in income brought about by additional investment would have been saved and therefore multiplier process would not have worked. Since the marginal propensity to consume is greater than zero, the increase in net investment has a multiplier effect on income, output and employment. Thus, the effect of investment on income depends on the size of the multiplier which depends on the value of the marginal propensity to consume. The greater the marginal propensity to consume, the greater the size of the multiplier.

(4) From the concept of consumption function, we can also explain why there is a tendency for the marginal efficiency of capital to decline. The declining tendency of the marginal effi­ciency of capital is due to the nature of the consumption function. Two features of consumption function are important. First, the marginal propensity to consume is less than one which implies that as income increases, consumption increases less than this. Secondly, consumption function is stable in the short run i.e., it does not shift much in the short run.

As we know that the level of investment is a crucial factor in the determination of income and employment, fluctuations in the levels of income and employment depend primarily on the fluctuations in investment. The investment demand in the short run is determined by the rate of interest on the one hand and marginal efficiency of capital on the other. Since the rate of interest is relatively sticky, it is the marginal efficiency of capital which greatly affects the level of investment in the short run.

Marginal efficiency of capital is nothing but the expected rate of profit on investment in the future. Thus, the marginal efficiency of capital is determined by the expectations of the entrepreneurs regarding the earning of profits from capital assets in the future.

Now, the most, important fact that affects the entrepreneurs expectations regarding profit prospects and thereby the marginal efficiency of capital is the level of future consumption demand for goods and services. Their estimate of future consumption demand depends on, among others, on the population growth. If population growth of a country is expected to fall as was estimated in the early thirties when Keynes wrote his book (General Theory of Employment, Interest and Money), this would adversely affect future consumption demand which in turn would adversely affect investment in the long run, Besides, according to Keynes, average propensity to consume (APC) falls as income of a community increases overtime.

This also adversely affects inducement to invest. If there does not occur capital-using technological change, this will result in decline in investment opportunities in the long run, causing secular stagnation. Thus we see that in the Keynesian scheme of things level of investment depends upon the level of consumption demand in the long run.

Since marginal propensity to consume is less than one and also the consumption function is stable when income increases, consumption does not increase proportionately. As a result, the aggregate demand becomes deficient and the marginal efficiency of capital declines. The decline in the marginal efficiency of capital adversely affects investment which stops rising. As a result, the growth process stops and economic recession occurs.

In this way, Keynes himself and later important Keynesian economist, Prof. A.H. Hansen developed the theory of secular stagnation for the mature capitalist economies. This secular stagnation theory is based upon the assertion that investment opportunities in a capitalist economy will be exhausted soon due to the absence of the possibilities of increasing consumption demand. The meagre possibilities of increasing investment in the mature capitalist economies, according to them, were partly due to the constancy of consumption function and declining average propensity to consume which caused the marginal efficiency of capital to decline.

Theory of secular stagnation has not been found true by empirical evidence in the last over seventy years of growth in the capitalist developed countries. However, the fact that current consumption is influenced by changes in rate of interest, stock of wealth and price level and further that it is the changes current consumption level that determine short-run business expectations about future yields from investment which cause fluctuations in investment.

Together with the working of multiplier fluctuations in investment cause business cycles in a free market economy. This shows the great importance of Keynes’s consumption function and the factors that determine it.

(5) As has been explained above, Keynesian concept of propensity to consume also helps us in explaining the turning points of a business cycle. The economy swings down from the peak it reaches because with marginal propensity to consume being less than one and average propensity to consume falling consumption demand does not increase as much as the increase in income and output. Over time this causes deficiency in aggregate demand which adversely affects investment demand by private business men.

Likewise, economy’s downward movement stops and it starts recovery because marginal propensity to consume being less than one, people do not reduce their consumption as much as the reduction in their income. Even during depression people try to maintain their previous level of consumption. This ultimately induces investment for replacement of capital goods which wear out over a period of business cycle. With the working of Keynesian investment multiplier recovery from recession gathers momentum.